Ratings Agencies

3 December 2007 at 2:39 pm 6 comments

| Steve Phelan |

One of my hobbies is to perform counterfactual exercises in organization design (yes, sad, I know). Here is my current challenge. Ratings agencies like Moody’s are paid by the issuers of securities rather than the purchasers of the securities. This creates an agency problem because the rater has an incentive to give high ratings to stay in the good graces of the issuer — who will presumably “shop around” to get the best ratings.

Assuming this arrangement is efficient then what are the counterbalancing factors that offset the agency costs? How much would agency costs have to increase to trigger an adjustment in design? Was the the subprime fiasco such a trigger? What would the new design look like?

I know that economists are reluctant to second-guess how the market will work out its problems — but strategists are in the business of being proactive about these things :-)

Entry filed under: Evolutionary Economics, Former Guest Bloggers, Institutions, Strategic Management, Theory of the Firm.

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6 Comments Add your own

  • 1. Adolfo  |  3 December 2007 at 5:21 pm

    I read with great interest your recent post at “Organizations and Markets” about rating agencies. To me, this reminds the failures we saw a few years back in the market for auditing. The structure of that market was such that one subject, the government, mandated public companies to purchase a product, the auditing, on behalf of a third party, the public. Go figure the incentive alignment! The real surprise was not that, at the end, the system did not work, but that its failure took so long to become apparent.
    The same mistake is now being repeated in the case of rating agencies. The service that this market provides is the assessment of credit risk. Rating agencies should be the provider of the service, and the public (investors & financial markets) should be the buyer. This structure would probably resolve the agency problem you mention. Otherwise, I doubt that variations on the same existing theme, or more regulation as somebody seem to suggest, would fix the problem of the incestuous relationship between companies and agencies. After all, if the majors paid reviewers to write about movies, who would trust film reviews?

  • 2. Anthony S.  |  4 December 2007 at 12:01 am

    What about reputation? Perhaps the arrangement between investors & credit agencies is non-monetary. The credit agencies may provide accurate ratings in exchange for reputation, which is ‘paid’ to them by investors.

    Investors pay more for higher rated securities, and the cash payment flows through the security to credit agency. Thus, while there is not a direct handoff of cash from investor to credit agency, an arrangement does exist.

    In the case of a low-quality security offering a credit agency more money for a higher rating — the credit agency would be hesitent to accept for fear of damaging its reputation when investors subsequently suffered.

  • 3. vincent poncet  |  4 December 2007 at 4:02 am

    If now rating agencies are paid by the issuers and not by the purchasers, it wasn’t always the case.

    http://www.portfolio.com/news-markets/national-news/portfolio/2007/08/13/Moody-Ratings-Fiasco?print=true
    “John Moody introduced credit ratings in 1909, with railroad bonds. Demand for an independent financial review of railroads was growing because of the industry’s volatility. Moody later moved into corporate bonds and made his mark in the wake of the 1929 stock market crash, when none of Moody’s top-rated bonds defaulted. Over the next several decades, his (and his ­competitors’) ratings became knit into the nation’s financial and regulatory fabric.

    Moody’s and S&P dominated for decades, and their business model was straightforward: Investors bought a subscription to receive the ratings, which they used to make decisions. That changed in the 1970s, when the agencies’ opinions were deemed a “public good.” The Securities and Exchange Commission codified the agencies’ status as self-regulatory entities. The agencies also changed their business model. No longer could information so ­vital to the markets be available solely by subscription. Instead, companies would pay to be rated. “That was the beginning of the end,” says Rosner.”

    As usual, the state destroy good incentives to put bad incentives. And now statesmens are saying that free-market isn’t working as there is collusion between issuers and an oligopoly of rating agencies. But statesmens are responsible of that, not the free-market.

  • 4. Twofish  |  4 December 2007 at 4:58 pm

    I think that having ratings paid by the buyer would have as many agency problems than having the ratings paid by the seller. The buyer has a very strong incentive to pad the ratings since a high rating for a risky bond allows the seller to put a high yielding bond in their portfolio, which is what happened with subprimes.

    One thing that should be pointed out is that rating agency ratings are based on public information and there is nothing to keep a person from making their own ratings.

  • 5. Twofish  |  4 December 2007 at 5:00 pm

    If you have a liquid market for credit default swaps, then there really isn’t much reason that I can see why a rating agency is necessary. The nice thing about credit default swaps is that people’s money is where their mouth is. If someone issues you a CDS and it goes bad, they owe you money.

  • 6. Cate Long  |  5 December 2007 at 11:23 am

    Two Fish… righto about CDS being useful as an indicator of relative creditiworthiness of a name.

    The new US regulatory framework for rating agencies allows an agencies to be recognized if they use quantitative methods.

    So we can expect to see some agencies register that use CDS… how about CMA or Markit?…

    http://www.shopyield.com

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